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Hunting for Hidden Giants

If you've spent any amount of time here at Fool.com, you know that we've got a newsletter service for small-cap investors called Motley Fool Hidden Gems. The approach taken by Fool co-founder Tom Gardner and his team emphasizes firms that generate big wads of owner earnings that have gone unnoticed by Wall Street because of their size.

But here's a news flash, folks: Just as not all penny stocks are bad, some stock market gems are positively huge. That's right. There are very large firms out there that don't get much attention on the Street. Sure, analysts cover them, but ownership among institutions is low compared with other large firms. Usually, there are good reasons for this. Witness Ford Motor (NYSE: F) . To say the carmaker has struggled is to say, well, the sky is blue, or the sun rises in the East.

Gems among giantsOther times, large companies are ignored because they aren't easy to love. Take foreign firms -- you know, the multinationals that trade in our market through what are called American depositary receipts, or ADRs. Though there's usually nothing wrong with these firms, it's just a tad harder to get and analyze their financial data than that of firms born and bred here in the good ol' U-S-of-A. That's true for even the most well-known of the ADRs, such as Nokia (NYSE: NOK) .

Were you to go to the investor relations website for Nokia, you'd find a downloadable cash flow statement that covers the past three years. Sweet. But if you want to check up on how the mobile phone maker is managing its greenbacks so far in 2004, you're out of luck. The firm doesn't report those numbers quarterly.

It's that lack of total visibility that sometimes makes even big investors squeamish, and keeps ownership of large but lesser-known foreign companies down, down, down. Sometimes it's to the point where insider ownership trumps institutional ownership. Ironically, that's a key attribute of some of Tom Gardner's most successful picks for Hidden Gems, including Hooker Furniture (Nasdaq: HOFT) and Fresh Del Monte Produce (NYSE: FDP) .

Screening in caves or on waves?Superinvestor Peter Lynch found that some giants aren't found in caves as the legends go, but rather across the pond. Read Beating the Street, Lynch's autobiography of his days running the Fidelity Magellan fund, and you'll find that some of his biggest winners were European giants, such as Volvo, which today is owned by Ford.

Far be it from me to ignore the teachings of a master like Lynch. So, just like last week, I again stole some insight from him to formulate my own screen. Call it the Hidden Giants criteria:

Metric

Requirement

Market cap

$7 billion or greater

Year-over-year cash flow growth

15% or better

Return on equity

20% or better

Institutional ownership

50% or less

As you can see, I'm looking for mid- to large-cap stocks that have gone unappreciated by institutional investors (50% or less in ownership) but that also have a history of growing their cash pipeline and delivering above-average returns on equity. Entering these criteria into my broker's screening tool yielded 28 potential candidates, mostly based outside the U.S. Yet the list contained some big names, including the aforementioned Nokia, British pharmaceutical giant AstraZeneca PLC, Dunkin' Donuts parent Allied Domecq, and French oil powerhouse Total SA.

None of them, however, interested me as much as Taiwan Semiconductor Manufacturing (NYSE: TSM) .

Taiwan Semiconductor: A chip and a clubThis is no average chip maker. In fact, it really isn't a chip "maker" at all. Pretty much everything there is to know about Taiwan Semiconductor Manufacturing can be found in its name. Just as Motley Fool Stock Advisor pick ARM Holdings (Nasdaq: ARMHY) designs chips but doesn't manufacture them, Taiwan Semiconductor manufactures chips but -- usually -- doesn't design them. Indeed, according to Standard & Poor's, 92% of the company's recent revenue came from filling orders for chips someone else designed.

Taiwan Semiconductor claims to have pioneered what it calls the dedicated foundry industry when it first opened for business in 1987. What's a foundry? It's a facility solely dedicated to the creation of all sorts of chips -- from PC semiconductors to memory chips to digital signal processors and the like. Taiwan Semiconductor has more than a dozen facilities in which it can produce the equivalent of 5 million 8-inch wafers of chips. In 2002, the company became the only pure production firm to join the list of the top 10 global integrated circuit companies, which includes heavies such as Intel (Nasdaq: INTC) and Texas Instruments. Yet a check of Yahoo! Finance shows institutions own less than 11% of the firm.

There's upside and downside to the production-only model, of course. When demand is hot, obviously, Taiwan Semiconductor follows suit. But when chip sales slow, capacity goes unused. Without a means to innovate and create its own market, Taiwan Semiconductor is beholden to the way the winds blow in its industry. But, folks, that's nothing new. The chip industry has experienced substantial down periods since the company first opened its doors, yet it continues to grow and its financial strength continues to improve. Just look at the numbers, all pulled from Morningstar:

Metric

2003

2002

2001

Sales

$5,877

$4,685

$3,709

Net income

$1,363

$624

$427

Gross margin

36.9%

32.2%

26.7%

Cash and equivalents

$3,019

$1,939

$1,070

Total debt

$1,476

$1,837

$1,495

Depreciation and amortization

$2,002

$1,876

$1,630

Capital expenditures

$1,096

$1,595

$2,068

Shareholders' equity

$9,652

$8,463

$7,899

Return on equity

15.08%

7.81%

5.66%

Numbers that are not percentages are in millions.

Increasing cash flow. A steadily improving balance sheet. Solid margins. The only bugaboo I see is in return on equity. Morningstar pegs last year's total -- the latest available because ADRs file a big report with the Securities and Exchange Commission called a 20-F only once yearly -- at well below 25%. Yet the stock screeners at Fidelity and Yahoo! Finance both show trailing 12-month ROE for Taiwan Semiconductor at better than 25%. I'll take it as a good sign, suggesting that ROE is seeing continued improvement.

As good as this company appears, there are, however, substantial risks. First and foremost, nearly every chip expert expects a downturn in 2005 that could get worse heading into 2006. Indeed, this is one of the reasons I suggested shorting Intel not long ago.

Second, Taiwan Semiconductor's 4.6 billion shares outstanding put it in the same league as mega-techs Intel, Cisco, and Oracle (Nasdaq: ORCL) . Part of the problem for each of those firms is the dilutive impact of stock options, and Taiwan Semiconductor is no different. (Though a check of the 2003 20-F suggests that the firm wouldn't see much of an impact from expensing stock options, as will soon be required. Still, this is worth watching.)

Should you buy Taiwan Semiconductor now? Maybe. It's trading for $7.99 per stub as of this writing and at what I'd estimate to be 15 times free cash flow. Neither of those numbers suggests an expensive stock. But remember that when Peter Lynch bought Volvo, he actually traveled to Europe to learn more. With some 16 Wall Street analysts weighing in on Taiwan Semiconductor, I doubt a trip to Taipei is in order. Still, if you plan to get in on this stock, you need to become an expert as Lynch did on Volvo and study its prospects and industry much more deeply than I can here.

Fee-fi-fo-FoolMuch as I like the idea of Hidden Giants, they're probably a whole lot rarer than their smaller jeweled cousins. But the hunt for them can be worthwhile. After all, larger firms are generally more stable and are usually more likely to pay generous, market-beating dividends. Multinationals are also by definition seeking growth by seeking capital away from their homeland. There's also plenty of financial and cultural learning to be had studying a business that doesn't operate primarily on American shores.

That said, foreign giants can be even riskier than American penny stocks. Plus, such risk is easily avoidable. You can get access to any number of great foreign firms through a well-designed mutual fund specializing in ADRs. If you choose to hunt giants on your own, just be sure you're entering the endeavor with a good understanding of the risks, and with a Foolishly diversified portfolio. No one wants to capture a promising giant only to see the beast grind his returns to make its bread.

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Tim Beyers first began writing for the Fool in 2003. Today, he's an analyst for Motley Fool Rule Breakers and Motley Fool Supernova. At Fool.com, he covers disruptive ideas in technology and entertainment, though you'll most often find him writing and talking about the business of comics. Find him online at timbeyers.me or send email to tbeyers@fool.com. For more insights, follow Tim on Google+ and Twitter.